Lecture_14_ - 2-1Lecture 14•Costs associated with...

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Unformatted text preview: 2-1Lecture 14•Costs associated with financial distress•Agency Cost2-2Description of Financial Distress Costs•Direct Costs–Legal and administrative costs •Indirect Costs–Impaired ability to conduct business (e.g., lost sales)–Agency Cost of Debt or the cost of conflict of interest between debtholders (lenders) and equityholders (borrowers)2-3Description of Financial Distress Costs•Conflict of interests between debtholders and equityholders lead to the following adverse strategies of the equity holders–Selfish Strategy 1: incentive to take large risk–Selfish Strategy 2: incentive toward underinvestment–Selfish Strategy 3: milking the property2-4Example: Company in DistressAssetsBVMVLiabilitiesBVMVCash $200$200LT bonds$300200Fixed Asset $400$0Equity$300Total $600$200Total$600$200What happens if the firm is liquidated today?The bondholders get 200 the shareholders get 0.2-5Selfish Strategy 1: Take RisksThe GambleProbabilityPayoffWin Big10%$1,000Lose Big90%$0Cost of investment is $200 (all the firm’s cash)Required return is 50%Expected CF from the Gamble = $ 1000 x 0.10 + $0 x 0.9 = $100NPV= - $200 + ($100/1.50)NPV= - $1332-6Balance Sheet and Values for Win Big (with 10% prob)AssetsBVMVLiabilitiesBVMVCash 0 LT bonds 300 300 Fixed Asset 1400 1000 Equity1100 700Total 1400 1000 Total1400 1000In case of “Lose Big” the firm will have absolutely nothing (0).2-7Selfish Strategy 1: Take Risks...
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Lecture_14_ - 2-1Lecture 14•Costs associated with...

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